TAX LAW COMMITTEE Committee Newsletter February 1999 Word from the Chair . . . By Jeffrey C. Adams We have many projects planned for the 1998-1999 year, and I encourage anyone who is interested to get involved. I think you will find that involvement in the Young Lawyers Division of the American Bar Association can provide a variety of benefits and opportunities, including networking with lawyers from across the country, planning and organization of CLE programs for ABA or YLD meetings, and the opportunity to be published in any number of ABA publications. During the past year, Tax Law Committee members published articles in the Young Lawyer, co-sponsored a CLE program with the Tort and Insurance Practice Section, and completed a membership drive which added 14 new members to the Committee’s Planning Board. In addition to these completed projects, members of the Planning Board are nearing completion of a desk-side guide to IRS practice. The Committee is also currently developing a CLE presentation for the 1999 Spring AOP in Boston which will address financial and estate planning for young lawyers. A website is being developed which will be linked to the YLD Home Page. Additionally, the Committee is considering a resolution on the practice of law by accountants and accounting firms to be presented at the ABA’s Annual Meeting in Atlanta. If you are not already a member of the Tax Law Committee’s Planning Board, or if you are interested in getting involved in any of the Committee’s projects, please do not hesitate to contact me. I can be reached at Morris, Manning & Martin, L.L.P., 1600 Atlanta Financial Center, 3343 Peachtree Road, N.E., Atlanta, Georgia 30326, telephone (404) 233-7000, or by e-mail at jca@mmmlaw.com. Jeff Adams is the chair of the Tax Law Committee for the 1998-1999 bar year. New Section 2057—Family Owned Business Deduction By Taci R. Darnell, JD, LLM, CFP The Taxpayer Relief Act of 1997 added code section 2033A, effective for estates of decedents dying after December 31, 1997. This provision provides estate tax relief for those estates that are comprised primarily of closely held stock. One year later, with the IRS Restructuring and Reform Act of 1998, the code section was redesignated as section 2057. Basically, section 2057 provides for the exclusion of the value of qualified family-owned business interests (QFOBIs) from the value of the gross estate if passed to a qualifying heir and held for a specific time period. However, section 2057 is very complicated and requires the taxpayer to jump through many hoops before realizing the benefits of the section. For example, the decedent must have been a resident or United States citizen to utilize this section. This article will describe the benefits of section 2057 and the requirements that must be satisfied in order to receive these benefits. Benefits of Section 2057 QFOBIs are now deducted from the gross estate to the extent that the value of the interest ($1.3 million maximum) exceeds the applicable exclusion. For example, in 1998 the applicable exclusion is $625,000. Therefore, up to $675,000 of a QFOBI may be deducted from the gross estate. As the unified credit increases to a maximum of $1 million in 2006, the family owned business deduction will be reduced to a maximum of $300,000 (i.e., $1.3 million less $1 million). Qualified Business Interests A qualifying business interest is defined in section 2057(e) as a sole proprietorship or "an interest in an entity carrying on a trade or business, if (i) at least (I) 50 percent of such entity is owned (directly or indirectly) by the decedent and members of the decedent’s family, (II) 70 percent of such entity is so owned by members of 2 families, or (III) 90 percent of such entity is so owned by members of 3 families." For purposes of (II) or (III), the decedent and members of the decedent’s family must own at least 30 percent of such entity. Members of the decedent’s family include the following individuals: the decedent’s ancestor; the decedent’s spouse; the decedent’s and/or decedent’s spouse’s lineal descendants and their spouses; and the decedent’s parents. Corporate ownership is determined by looking at the amount of voting stock owned and the total value of shares of all classes of stock. For partnership interests, the capital interests in the partnership determine ownership. The business must be located in the United States, cannot be a publicly traded company within three years of the date of the decedent’s death, and cannot be a business with greater than 35% personal holding company type income (i.e., portfolio income). Material Participation The decedent or a member of the decedent’s family must have materially participated in the business for a period aggregating five years during the previous eight years. Material participation is not defined in the statute and is not reduced to a specified number of hours worked. No one factor is determinative, but physical work and participation in management decisions are the principal factors to be considered. The passive activity rules generally require 500 hours per year to meet material participation. 50% Liquidity Test The adjusted value of the decedent’s QFOBI that passes to qualifying heirs must exceed 50% of the decedent’s adjusted gross estate. Included in the valuation of the QFOBI is the amount of the QFOBI gifted to members of the decedent’s family during the decedent’s life time, including those gifts that were excluded by the annual exclusion, to the extent that those gifts have been continuously held by a member of the decedent’s family. The value of such gifts is added back using the valuation at the date of transfer. Any debts of the decedent are presumed to be debts that reduce the QFOBI value, except for the following: (1) most qualified residence debt; (2) debts incurred to pay medical or education expenses for either the decedent, the decedent’s spouse or the decedent’s dependents; or (3) other debt up to $10,000. In evaluating the 50% test, it is important to include the following two adjustments to the QFOBI valuation. First, the value of a qualifying business interest is reduced by the amount of excess cash or marketable securities held that exceed the reasonable day-to-day working capital needs of the business. Second, the value of the QFOBI is reduced by any asset that produces or is held for the production of personal holding company income (i.e., portfolio income). Qualifying Heirs In order to utilize this section, the QFOBI must be passed to qualifying heirs. A qualifying heir includes the previously defined family members and any active employee who has been employed for at least 10 years. This allows business owners who have employees that have become "like family," although they may not be blood relations, to utilize this provision. A qualifying heir does not have to be a United States citizen, but such heir’s interest must be held in a qualifying trust. Recapture Provisions An additional estate tax will be assessed if one of the following events occurs within 10 years of the decedent’s death and before the date of a qualifying heir’s death: (1) the material participation requirement is no longer satisfied; (2) a qualifying heir disposes of any portion of QFOBI to a nonqualifying heir ; (3) a qualifying heir loses its United States citizenship and does not transfer the interest to a qualified trust; or (4) the business ceases to be located within the United States. The amount of the additional estate tax imposed is the applicable percentage of the adjusted tax difference attributable to the QFOBI, plus interest on the additional tax assessed at the underpayment rate, as provided in section 6621. The applicable percentage varies depending upon how many years a qualifying heir has held the QFOBI. A disqualifying event occurring within the first six years is taxed at an applicable percentage of 100 percent, and is reduced by 20 percent each succeeding year as follows: Year                            Percent 1 through 6                  100 7                                   80 8                                   60 9                                   40 10                                 20 11                                   0 The estate tax recapture is especially onerous since a qualifying heir who triggers the recapture tax may not be the party who is liable for the estate taxes. For example, if one child receives the stock of the corporation but the other child receives all other assets, the additional burden of the recapture may fall on the child with the other assets even though such child had no control over triggering the recapture. This can pose a difficult dilemma. If the estate plan documents provide that the taxes are to be paid out of the residuary estate, it is in the best interest of the child receiving the non-QFOBI to utilize section 2057. However, the child receiving the stock will be bound to keep the stock for at least 10 years to avoid the estate taxes. When preparing an estate plan for a closely held business owner, these issues must be discussed up front to eliminate familial disputes later. Conclusion Section 2057 is very complicated and has many limitations. Since it is a new section it will be a while before case law is developed and regulations promulgated to assist in its practical application. Nevertheless, it is an estate planning tool that should be considered when dealing with clients with closely held businesses. Taci Darnell is a tax manager with Feeley & Driscoll, P.C. in Boston, Massachusetts. Ms Darnell specializes in estate planning and international taxation issues. Ms. Darnell is also a member of the YLD Planning Board. Check Out ABA-YLD Tax Law Committee’s New Website By Melinda S. Merk Our Committee’s new website can be accessed at http://www.abanet.org/yld/tax/home.html. The website includes a message from our chair, Jeffrey C. Adams, which discusses the various projects that our Committee is working on and invites new members to get involved. This issue and recent past issues of our CommitteeNews newsletter will also be posted. Visitors to our website can keep up on recent tax law developments by viewing articles published by our Committee members. We have also provided links to various tax law, government, business and news websites. Important information regarding upcoming ABA-YLD meetings will also be posted, in addition to a roster of Committee members. The ABA-YLD Tax Law Committee website will be the place for young lawyers to get up-to-date news and information on important tax law developments and Committee projects. Suggestions for our website may be submitted to the author at melinda.merk@ey.com. Check us out on the net! Melinda S. Merk practices with the National Tax Office of Ernst & Young, LLP in Washington, DC. Ms. Merk is also a Vice Chair of the YLD Planning Board. IRS Releases New Forms W-8 Withholding Certificates By Gabriela Franco The Internal Revenue Service ("IRS") issued new Forms W-8 on November 23, 1998. These new forms were released in connection with final regulations published on October 14, 1997 (62 FR 53387) and revised on December 31, 1998 (63 FR 72183). Those regulations provide for income tax withholding on certain United States source income payments made to foreign persons after December 31, 1999 and pursuant to Internal Revenue Code sections 1441, 1442 and 1443. In addition, the regulations provide for the use of several withholding certificates the use of which will be mandatory after December 31, 2000. Accordingly, the IRS has issued four new Forms W-8 that should be provided by certain foreign persons to the withholding agents. Effective January 1, 2001, the new forms will replace the existing Forms W-8, 1001, 4224, 8709 and 1078. Each new Form W-8 is described below. Form W-8BEN Form W-8BEN (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding) will be used by foreign persons that are the beneficial owners of income subject to withholding, whether or not such foreign person is claiming a reduced rate of withholding tax or exemption from withholding tax. Form W-8BEN may be used to claim a reduced rate of, or exemption from, withholding as a resident of a foreign country with an income tax treaty with the United States. Form W-8ECI Form W-8ECI (Certificate of Foreign Person’s Claiming for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States) should be used when a foreign person is the beneficial owner of income that is includible in such persons gross income for the tax year and such person claims that the income is effectively connected with the conduct of a trade or business in the United States. If a foreign person expects to receive income that is partly effectively connected with a trade or business and partly not effectively connected, then such person should provide Form W-8ECI for the effectively connected income, and one of the other three forms for the non-effectively connected income. Form W-8EXP Form W-8EXP (Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding) should be used by foreign persons claiming a reduced, or eliminated, withholding rate of tax as a foreign government, international organization, foreign central bank of issue, foreign tax exempt organization or foreign private foundation. Form W-8IMY Form W-8IMY (Certificate of Foreign Intermediary, Foreign Partnership, or Certain U.S. Branches for United States Tax Withholding) should be used by the following: (i) foreign intermediaries to represent that they are qualified or nonqualified intermediaries for the payments they receive and not the beneficial owner, (ii) foreign partnerships to establish the status of the partnership or of its partners as foreign persons, (iii) a foreign person that is the trustee or executor of a United States or foreign trust or estate, (iv) a United States branch of certain foreign banks and insurance companies to represent that the income it receives is not effectively connected with the conduct of a trade or business in the United States and that it is using the certificate to transmit the documentation of the person for whom it is acting as intermediary or to evidence an agreement with a withholding agent to be treated as a United States person; or (v) a reverse hybrid entity claiming treaty benefits on behalf of its interest holders. Effective Date The new forms can be used immediately. As described below, the IRS has provided transition rules to deal with the transition from the existing forms to the new forms. Period of Validity for Each Form W-8BEN. A Form W-8BEN that is provided without a taxpayer identification number ("TIN") is generally effective for a period beginning the date the form is signed and ending on the last day of the third succeeding calendar year unless there has been a change in circumstances making the information provided incorrect. A Form W-8BEN containing a TIN will be valid as long as the submitter’s status and the information relevant to the submitter’s certification remains unchanged. W-8ECI. A Form W-8ECI is generally effective for a period beginning the date the form is signed and ending on the last day of the third succeeding calendar year unless there has been a change in circumstances making the information provided incorrect. W-8EXP. A Form W-8EXP that is provided without a TIN is generally effective for a period beginning the date the form is signed and ending on the last day of the third succeeding calendar year. However, if the W-8EXP is filed by an integral part of a foreign government or a foreign central bank of issue, a form that is filed without a TIN will be effective until there is a change in circumstances making any information on the form incorrect. A Form W-8EXP containing a TIN will be valid until there is a change in circumstances making the information on the form incorrect. W-8IMY. A Form W-8IMY will generally remain in effect until the status of the person named on the certificate is changed in any way that is relevant to the certificate or circumstances change such that the information provided on the certificate is no longer correct. This indefinite validity period does not extend to any certificates or other documentation attached to the certificate nor does it extend to any statements attached to the certificate if circumstances change making the information on the attached statements incorrect. Transition Rule Under transition rules announced in TD 8804 (63 FR 72183): (i) existing withholding certificates that were valid on January 1, 1998 and expired during 1998 may be treated as valid until December 31, 1998, (ii) existing withholding certificates that expire in 1999 will not be valid after their expiration and (iii) existing certificates that were valid on December 31, 1999 may be treated as valid until the earlier of their expiration or December 31, 2000. IRS Web Site The new withholding certificates and instructions are available on the IRS web site at http://www.irs.ustreas.gov/prod/forms_pubs/forms.html. Gabriela Franco is Vice President & Counsel at Mellon Capital Management Corporation in San Francisco, CA and is a member of the YLD Planning Board. Tax Law Committee 1998-99 Planning Board Chair:                  Jeffrey C. Adams Vice Chairs:        Gabriela Franco                            James D. Lockhart                            Melinda S. Merk                            Patrick T. Schmidt                            Susan Ward                            Deborah A. Wisnowski Planning Board:   Allison Taylor Craft                            Taci Darnell                            David E. Dreyer                            Michelle L. Gullet                            Kimberly Jenkins DeWeese                            Emily Moore                            Mark Moose                            Lisa Newman                            Candice I. Polsky                            Daniel G. Russo                            Sonia S. Sharma                            Audra J. Simovitch                            Raj Tanden                            William D. Wright Interested in Getting Involved in an ABA YLD Tax Law Committee Project? Committee Website Development: Contact Melinda Merk at melinda.merk@ey.com or (202) 327-6515 Deskside Guide to IRS Practice: Contact Patrick Schmidt at patrick.schmidt@ey.com or (502) 585-6507 1998-99 Planning Board: Contact Jeff Adams at jca@mmmlaw.com or (404) 233-7000 Future Issues of Committee News: Contact Gabriela Franco at gabriela@mcm.com or (415) 975-2356; or Deborah Wisnowski at dwisnowski@kilstock.com or (202) 508-5852 Committee Resolution Development: Contact Melinda Merk at melinda.merk@ey.com or (202) 327-6515 The articles and reports contained herein reflect the views of the individuals who proposed them and do not necessarily represent the positions of the American Bar Association, the Young Lawyers Division, or the ABA YLD Tax Law Committee. © 1999 American Bar Association, Young Lawyers Division.  All Rights Reserved.